Energy analysts are getting worried about oil drillers’ spending again

U.S. oil and gas drillers have cleaned up their balance sheets over the last year, but some analysts worry they are growing production at the expense of financial discipline.

Drillers look healthier today after slashing capital spending, putting dollars behind their most productive land and securing discounts from the companies that help them extract oil from their wells. But many are still spending beyond their means to hike output at a time when analysts are cutting their oil price forecasts.

Some analysts worry that some drillers could find themselves in a familiar and unwelcome situation: searching for funding to keep oil flowing.

Today, a recovery in earnings has helped drillers reduce relative debt levels that soared at the bottom of the oil market. And while many drillers are still spending more than they make, their cash flow has generally improved.

The imbalance between debt and earnings is expressed as the debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. As earnings rise and debt either falls or remains steady, drillers look healthier.

The average debt level for a group of 38 drillers fell from a high of more than 8 times EBITDA in the second quarter of 2016 to a much healthier 3 times EBITDA last quarter. Data were not available for several drillers that went bankrupt last year.

Investors care about free cash flow because it shows how much money drillers have to spend on investments like acquiring new assets.

Discipline vs. growth

As oil prices rose throughout much of last year and the first quarter of 2017, the number of oil rigs drilling wells in the United States more than doubled. American production rebounded from a low of about 8.4 million barrels a day last fall to roughly 9.4 million barrels a day.

Some analysts worry that drillers are getting ahead of themselves, especially with U.S. crude prices losing steam and remaining stuck below $50 a barrel.

“Most investors shared our view that U.S. onshore growth is unsustainable in the $40-$45/bbl price environment and that activity would need to be reduced to better balance corporate cash flows and” capital expenditures, Stifel analysts said in a research note earlier this month.

“Our end conclusion is we need less rigs and more capital discipline.”

There are signs drillers will throttle back production. On Tuesday, Anadarko Petroleum reported it would cut its 2017 capital spending program by $300 million because profit margins from selling crude have been volatile this year.

The announcement is significant because Anadarko serves as a bellwether for quarterly earnings, said Timothy Rezvan, managing director of energy research at investment bank Mizuho Americas.

As producers begin reporting second-quarter results this week, similar announcements — and the stock reaction — will shed light on whether investors now prize discipline and efficiency over production growth, he said.

“With that said, you still have a game of chicken with the companies that like to flex their muscles,” he said.

Excuses, excuses

Drillers surveyed by Mizuho justified persistent free cash flow deficits by saying they need to keep spending so that earnings would offset borrowing. They also claimed they are pulling forward the value of their wells with today’s high output.

But Rezvan countered that the spending could force drillers to reduce their activity if oil prices don’t rally in the medium-term. Some smaller companies could find themselves in need of debt or equity financing, but that window might not be open, he said.

Rezvan also questioned whether it benefits shareholders to pull forward production when oil is fetching less than $50 a barrel. Prices for future contracts are relatively flat, which gives drillers fewer opportunities to lock in a price for future deliveries with traders concerned that prices will rise further.

U.S. shale drillers rely on expensive advanced drilling methods to extract oil and gas from rock formations. The industry is still relatively young, so it makes sense that many drillers have struggled to generate positive cash flow since 2010, according to a report released Wednesday by commodity research firm Wood Mackenzie.

“Like any high-growth, capital-intensive investment, the first years are a poor indicator of future profitability,” wrote Andy McConn, analyst at Wood Mackenzie. “To date, high early-life costs have weighed on cash-flow metrics, but tight-oil producers have made great strides in honing technology and reducing costs.”

Wood Mackenzie said some of the top shale producers could generate positive cash flow by 2020. But it too warned that a focus on growing production could destroy value.

“By prioritizing production growth over profitability and margins, investors and producers are at risk of killing their goose before it lays a golden egg,” according to Wood Mackenzie analyst Benjamin Shattuck.

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